Slow capital, fast prices: Shocks to funding liquidity and stock price reversals

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1 Slow capital, fast prices: Shocks to funding liquidity and stock price reversals Stefan Gissler Federal Reserve Board This presentation does not reflect the views of the Federal Reserve System. 1

2 Stock market volatility during 2008/2009 VIX Jan Apr Jul Oct Jan Apr 09 Date 2

3 This paper German stock market during Great Depression 5 big banks acted like market makers Each bank provided liquidity to a different subset of stocks I identify a shock to the funding liquidity of one bank, the Danatbank 11 May 1931: Largest borrower is near bankruptcy During May 1931: Constrained liquidity provision of Danatbank to each of its other firms Difference-in-differences approach Main results: Increase in illiquidity measured by order imbalances V-shaped price patterns 3

4 Main results Volatility Danat firms 15 Mar Apr May 31 Date Volatility Other firms 15 Mar Apr May 31 Date 4

5 Related Literature Limits to arbitrage and frictional finance De Long et al. 1990, Duffie et al. 2005, Biais 2011 Price pressure and V-shaped price patterns Kraus and Stoll 1972, Coval and Stafford 2007, Duffie 2010, Hendershott and Menkveld 2013 Intermediary's balance sheet and asset prices Coughenour and Saad 2004, Comerton-Forde et al 2010, Adrian and Shin 2010 Gromb and Vayanos 2002, Brunnermeier and Pedersen 2009 Pre-WW II Germany De Long and Becht 1994: no excess volatility in pre-ww II German stock market 5

6 Historical background The big Berlin banks as liquidity providers Interwar Germany: only 5 universal banks Banks held close connections to firms Creditor, underwriter, supervisory board etc. On the stock exchange, banks acted like market makers for stocks of connected firms 6

7 Historical background The big Berlin banks as liquidity providers "...sometimes the demand or supply of a few shares can lead to unreasonable price increases or decreases. Here it is the task of the bank to provide liquidity in order to establish a more balanced price setting. The underwriting bank can fulfill this task best, since it is mostly better informed about the true value of the shares... " (A. Weber 1915) 7

8 The funding liquidity shock Danatbank 's largest borrower: Nordwolle Credit: 80% of Danatbank's equity May 1931: Nordwolle on the verge of bankruptcy Danatbank's CEO Goldschmidt: "Nordwolle goes down, Danat goes down, I go down!" Danatbank's reaction: No disclosure of information Planned equity offering (with Danatbank as main buyer) Danatbank "sought desperately to find means of supporting Nordwolle" (Feldman 1995) Secretly buying own shares In June information became public 8

9 Data IPO and SEO prospectuses and bank annual reports (German Federal Archives) Daily stock market data for 87 firms (Berliner Boersen Zeitung) Period: ( firm-day observations) Other archival sources (letters, reports etc.) 9

10 Data description Danat firms Other firms Di erence Manufacturing No.of firms % in group sample Median book value (Mio RM) Mining No. of firms % in group sample Median book value (Mio RM) Utilities No. of firms % in group sample Median book value (Mio RM) Finance No. of firms % in group sample Median book value (Mio RM) n.a. n.a. Geographical location No. of firms located in Berlin % in group sample

11 Market illiquidity Frequency of supply order imbalances Before May 11 After May 11 Total BHG Commerz Deu-Dis Danat Dresdner

12 Market illiquidity: Baseline results Imbalance it = β 1 Danat i +β 2 May p +β 3 (May p Danat i )+α i +δ t +ϵ it (1) (2) (3) May Danat 0.158*** 0.167*** 0.181*** (0.0438) (0.0470) (0.0507) May BHG (0.0319) (0.0394) May Commerz (0.0423) (0.0553) May DeuDis (0.0380) (0.0386) May Dresdner (0.0449) (0.0441) Time FE Yes Yes Yes Firm FE Yes Yes Yes Size Yes SizeMay Yes N R Logit. 12

13 Market illiquidity: Placebo test Regression coefficient Nov Dec Jan Feb Mar Apr May Jun Month Danat Commerz Dresdner BHG Deu-Dis 13

14 V-shaped price patterns Danatbank firms before May Danatbank firms during May Cum. returns Cum. returns Days after illiquidity Days after illiquidity Other firms before May Other firms during May Cum. returns Cum. returns Days after illiquidity Days after illiquidity 14

15 Investing in illiquidity: A contrarian trading strategy Returns (%) Nov 30 Dec 31 Jan 31 Feb 28 Mar 31 Apr 30 May 31 Date Daily returns Accumulated returns 15

16 Investing in illiquidity: A contrarian trading strategy Cum. returns May 05 May 10 May 15 May 20 May 25 May 30 Jun 04 Day Danat Commerz Dresdner BHG Deu-Dis 16

17 Robustness: Firm news Frequency of news Feb Mar Apr May 17

18 Stock prices Price index Nov 30 Dec 31 Jan 31 Feb 28 Mar 31 Apr 30 May 31 Date Danat firms Other firms 18

19 Robustness: Banks' stock prices Price February 28 March 31 April 30 May 31 Date Danat Commerz Dresdner BHG Deu-Dis 19

20 Conclusion Case study where balance sheet shock had asset pricing implications Unique setting: Clear identification of liquidity provider Large balance sheet shock V-shaped price patterns Discussion on universal banking: More prone to shocks 20

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22 May Danat 0.158*** 0.167*** 0.181*** (0.0438) (0.0470) (0.0507) May BHG (0.0319) (0.0394) May Commerz (0.0423) (0.0553) May DeuDis (0.0380) (0.0386) May Dresdner (0.0449) (0.0441) Time FE Yes Yes Yes Firm FE Yes Yes Yes Industry FE Yes Yes Yes Size Yes. SizeMay. Go back Yes N R Market illiquidity: Logit results Exc.supply it = β 1 Danat i +β 2 May t +β 3 (May t Danat i )+α i +δ t +ϵ it Table 2 (1) (2) (3) Logit Logit Logit May*Danat 1.662*** 1.887*** 2.029*** (0.327) (0.472) (0.494) May*BHG (0.223) (0.313) May*Commerz (0.470) (0.485) May*DeuDis (0.443) (0.466) May*Dresdner (0.367) (0.391) Time FE Yes Yes Yes Firm FE Yes Yes Yes Industry FE Yes Yes Yes Size Yes SizeMay Yes N Pseudo R

23 Volatility during May/June Danat firms Return variance May 14 May 28 Jun 11 Jun 25 Date 23

Slow capital, fast prices: Funding liquidity shocks and stock price reactions

Slow capital, fast prices: Funding liquidity shocks and stock price reactions Stefan Gissler PRELIMINARY DRAFT January 10, 2012 Abstract Does the capital of a liquidity supplier matter for asset prices?